For more information on the CBOE Volatility Index^® ("VIX"), volatility and variance futures including brokers, ISVs, symbols and product specifications, visit www.cboe.com/cfe.

To contact the CFE, please click here.

Futures in Volatility includes several sections: Market Summary and Analysis, Trading Strategy Ideas, and Events. Market Summary and Analysis includes commentary related to VIX, VIX futures and other volatility products, as well as charts and data related to these markets. Trading Strategy Ideas features strategies focused on trading volatility products. And, Events features upcoming CFE and Chicago Board Options Exchange (CBOE^®) conferences, seminars and webinar presentations.

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Contact Information

Please direct questions concerning this circular to Jay Caauwe at (312) 786-8855 or caauwe@cboe.com.

VIX Futures Last Trade Dates

Announcements

"VIX FUTURES AND OPTIONS: A CASE STUDY OF PORTFOLIO DIVERSIFICATION DURING THE 2008 FINANCIAL CRISIS" RELEASED

A recently released University of Massachusetts study found that certain investments in futures and options on the CBOE Volatility Index^® (VIX^®) could have reduced downside risk for a typical institutional investment portfolio during the 2008 financial crisis.

Settlement Information

The Final Settlement Price for VIX Futures is determined from a Special Opening Quotation (SOQ) of VIX. The SOQ is calculated from the sequence of opening prices of the SPX options used to calculate the VIX index on the settlement date (the "Constituent Options"). The opening prices for SPX options used in calculating the SOQ are determined through an automated auction mechanism ("Hybrid Opening System" or "HOSS") that matches buy and sell orders residing on the Electronic Order Book prior to the opening of trading. We ask that all market participants review the procedures pertaining to settlement

Market Summary and Analysis is provided by Larry McMillan. Mr. McMillan is the President of McMillan Analysis Corporation. Click Here for more information about Mr. McMillan.

August Settlement

The August CBOE Volatility Index® ("VIX"®) futures contract settled at 28.76 on Wednesday, a relatively high level considering the fact that the bullish stock market trend is ongoing. There was a bit of surprise over the settlement. The night before, VIX had closed much lower at 26.08. Overnight, however, there was heavy selling in Europe and Asia, and the corresponding S&P 500 futures traded down more than 10 points. By the time U.S. markets were set to open on Wednesday morning; those S&P futures were still down 10 points. As is the case, a sharp decline in the stock market may cause a sharp spike upward in VIX. Therefore, VIX was expected to open higher, and it did with 28.08 being the first tick in VIX itself.

However, the settlement value for VIX futures is calculated differently from how the VIX is calculated on non-settlement days. In both cases, prices of S&P 500® Index options ("SPX options") traded on CBOE are used. On non-settlement days, VIX is calculated using the average of the bid and ask of the relevant SPX option series, whereas on settlement days the VIX is calculated using the actual first trade (if one occurs in the relevant SPX option series). For August expiration, the September S&P 500 Index options were used in the VIX settlement computation..

There was some anxiety in the market on Wednesday morning, with the decline in the overnight markets and the S&P futures set to open 10 points lower. This produced an apparent bid, or buying, bias for S&P 500 Index September put options. Traders were willing to pay higher for puts, and thus the first trade took place on the offer side of the option market. That primarily explains why the VIX settlement, 28.76, was higher than the first VIX tick of 28.08.

Traders Continue To Expect Higher Volatility

VIX futures continue to trade with extremely high premiums, reflecting trader's expectations of higher volatility in the next few months. This opinion is so prevalent that it has nearly reached a consensus.

                                              Source: MAC

From table 1, you can see that the highest premium is the October VIX futures which are based on the prices of the November SPX options. The premium remains high in the November and December futures as well. Anything over 2 point's premium is considered large, and these are above 4 and nearly 5 in the case of October.

The September futures are not trading with as much premium, which might seem strange at first. History has pointed to the downside risk factor usually occurring prior to October expiration. But the reality of the situation is that September VIX futures and options expire on September 16th, which is only 23 days away. By the time those 23 days are spent, VIX and September VIX futures will be trading at the same price. Therefore, it appears that traders are lowering the premium on the September futures merely because of the time decay.

Figure 1                                               Source: McMillan Analysis Corp.

Figure 1 shows the current term structure of all the VIX futures contracts through March. This unusual shape, with the second month being the highest in price, may be reflective of the appetite of traders to own October volatility.

In the past, VIX futures have been used as a market pricing predictor. Trader consensus was likely reflected in the VIX futures pricing structure and it was a good predictor about the market's upcoming movements. For example, large VIX futures premiums appeared to be a predictor that VIX was about to rise. Typically, when VIX rises, the broader market is falling. Large VIX futures premiums are typically a bearish forecast for the stock market. Conversely, large VIX futures discount or futures trading at prices below the price of VIX are typically a bullish forecast for the stock market.

That was not the case this time, as the existing large VIX futures premiums have been in place for some time and the market has continued to rise. It appears as though this recent large VIX premium has not been produced by the same trader sentiment as before, but rather by a consensus of opinion that VIX will rise this fall. Often when a consensus expects something to happen, it does not. In fact, the opposite sometimes occurs.

Trading Strategies

We have written in the past two months about the hedged strategy that one might use to trade this market of unusually high VIX premiums (buy SPX and VIX puts). But there are other strategies that could be used as well.

Speculation

The outright purchase of VIX puts, for example, is a speculative strategy that tends to have a built-in advantage. That is, if the futures are wrong and they eventually decline to the price of VIX by expiration, then the VIX put buyer will typically profit. Even if the VIX futures are right and VIX rises to meet the futures, the futures themselves might not move much higher, and so a put purchase would not likely lose much, except the time value premium. Traders, who are attracted to this line of thinking, but leery of the time value expense, may consider shorting the VIX futures. Again, if they decline to meet VIX, one may profit. But even if VIX rises to meet the futures, the futures might not move much higher. Of course, the futures short sale has large upside risk if another downside stock market panic develops.

Spread Position

A less aggressive strategy would be to try to play the large spread between the September and October futures, which stood at 2.65 points at Friday's close. That is a very large number, and will not likely be able to sustain itself. September and October should converge, lessening the steep slope of the term structure. There was a similarly large premium between August and September VIX futures a month ago (2.55 in last month's issue). If one had bought August and sold September, a trader could have realized a profit by expiration. So one could buy September VIX futures and sell October VIX futures, looking for the spread to shrink. The risk with that strategy is that the spread could widen further. An option trader might approach this situation by buying September calls and buying October puts.

About CBOE Futures Exchange

CBOE Futures Exchange (CFE^®) is an all-electronic open access exchange, which utilizes the CBOE’s^® state-of-the-art trading system, CBOEdirect^®. CFE is the leader in providing innovative volatility risk management futures products, including VIX^® and variance futures, which enable market participants to manage volatility risk, as well as trade volatility directly. Access to CFE is available through numerous brokers, ISVs or directly via the CBOEdirect API or CBOE’s HyTS^® terminals. CFE trades are cleared by the AAA-rated Options Clearing Corporation (OCC). To contact the CFE, please click here.

About Larry McMillan and McMillan Analysis Corporation

Professional trader Lawrence G. McMillan is perhaps best known as the author of Options As a Strategic Investment, the best-selling work on stock and index options strategies, which has sold over 200,000 copies. An active trader of his own account, he also manages option-oriented accounts for certain individuals and in addition, he is the Portfolio Manager of The Hardel Volatility Arbitrage Fund (a hedge fund). In a research capacity, he edits and contributes to his firm’s publications: Daily Volume Alerts, The Option Strategist and The Daily Strategist—derivative products newsletters covering equity, index, and futures options. Finally, he speaks on option strategies at many seminars and colloquia in the United States, Canada, and Europe. He is quoted in publications such as The Wall Street Journal, Barron’s, Technical Analysis of Stocks and Commodities, Data Broadcasting’s Exchange magazine, Futures Magazine, theStreet.com, and Active Trader Magazine. In these capacities, he is the President of McMillan Analysis Corporation, which he founded in 1991. Prior to founding his own firm, Mr. McMillan was a proprietary trader at two major brokerage firms—primarily Thomson McKinnon Securities, where he ran the Equity Arbitrage Department for nine years.

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CFE®, CBOE®, Chicago Board Options Exchange®, CBOE Volatility Index®, VIX® are registered trademarks of Chicago Board Options Exchange, Incorporated.

The information in this newsletter is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions that should be referred to for additional detail and are subject to changes that may not be reflected in this newsletter. The strategy discussions contained in this newsletter are designed to assist individuals in learning how volatility and variance futures as well as other volatility-based derivatives work and understanding various volatility derivatives strategies. The strategies discussed are for educational and illustrative purposes only and should be not be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. Additionally, commissions and other transaction costs have not been included in the example strategies and will impact the outcome of security and futures transactions and must be considered prior to entering into any transactions. Investors considering volatility-based derivatives should consult a professional tax advisor as to how taxes affect the outcome of contemplated transactions in volatility-based derivatives. The charts and/or graphs contained herein are intended for reference purposes only. Past performance is not indicative of future results.

The views of third party contributors to this newsletter are their own and do not necessarily represent the views of CFE or its affiliates. Third party contributors are not affiliated with CFE. This newsletter should not be construed as an endorsement or an indication by CFE of the value of any third party product or service described in this newsletter.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606.

The methodologies of the CBOE Volatility Index (VIX) and the CBOE DJIA Volatility Index (VXD) are owned by CBOE and may be covered by one or more patents or pending patent applications.